Managing Your Retirement
[Editor's Note: Warning. Some of what follows -- no, make that all of what follows -- may not be as amusing as what you've come to expect from The Motley Fool. We've given the humorous treatment of receiving shares of company stock at the time of retirement a good deal of thought. We've had professional comics come in and look over the material -- discuss the witticisms that can be attached to the "excluded appreciation as of the distribution date" and "the holding period in those shares begins on the day after the day the plan trustee delivers the shares to the transfer agent on your behalf." Though we strive to educate, enrich, and amuse (not necessarily in that order), there are limits to all things. There are certainly limits to the amount, and more importantly, to the quality of comedy that can even be attempted with such topics. If somebody somewhere else on this whole World Wide Web thing has produced a humorous treatment of the tax consequences of taking stock from a an employer's qualified retirement plan, please alert us -- and we'll swipe it.]
We were saying.
When company stock is received as part of a lump-sum distribution from a defined contribution plan, your plan's provisions may allow you to handle that distribution in one of four ways:
- Transfer the shares to an Individual Retirement Account (IRA).
- Sell the shares and transfer the cash from that sale to an IRA.
- Keep the stock and pay ordinary income taxes on the cost basis of the shares. Gains on a subsequent sale are eligible for capital gains treatment.
- Keep the stock and pay ordinary income taxes on the market value of the shares at the time of distribution.
(Note: In all cases, fractional shares will be redeemed by the plan for cash.)
Transferring Shares to an IRA
Transferring shares to an IRA is advantageous in that the distribution avoids immediate taxation, and the tax deferral continues until the funds are ultimately withdrawn from your IRA. When the distribution from the IRA consists of actual shares of stock instead of cash, the shares will be valued at market as of the day of withdrawal, and that amount must be declared as income for tax purposes. The market value of those shares then becomes the new basis, and the holding period for calculating capital gains on a future sale of those shares begins on the day after the day of distribution from the IRA.
Selling the Shares and Transferring the Cash to an IRA
On withdrawal from the IRA, the sum taken will be taxed at the ordinary income tax rates in effect in the year of distribution.
Keeping the Stock and Paying Ordinary Income Tax on the Cost Basis of the Shares
You will pay ordinary income taxes on the cost basis of the shares taken in the year of distribution. Additionally, those younger than age 55 at the time of separation must pay an early withdrawal penalty of 10% on the cost basis as well. Your plan administrator will tell you what the cost basis is. Your holding period in those shares begins on the day after the day the plan trustee delivers the shares to the transfer agent on your behalf. Any unrealized appreciation (i.e., the difference between market value on the day of distribution and your cost basis) is not recognized until a later sale; however, any gain attributable to the excluded appreciation as of the distribution date from the plan will be treated as a long-term capital gain regardless of your holding period. Any gain exceeding that as of the day of distribution will be considered a long- or short-term capital gain based on your holding period after the shares were distributed.
Keeping the Stock and Paying Ordinary Income Taxes on the Market Value of the Shares at the Time of Distribution
In the fourth choice, you will pay ordinary income taxes on the market value of the shares as of the day of distribution from the plan. Your holding period in those shares begins on the day after the day the plan trustee delivers the shares to the transfer agent on your behalf. Any gain on a subsequent sale will be considered a long- or short-term capital gain based on your holding period after the shares were distributed.
Making a Decision
Which is the best choice for you? Ah, now, there's the rub. Like so many things connected with taking distributions from a retirement plan... it depends. The factors involved include your desire to retain the stock (Do you have some emotional attachment to it? Do you just want to be rid of any association with that employer?), your income tax situation, and your estate-planning desires.
Let's consider a hypothetical person who we'll call Vespasian. Vespasian is in the 28% federal income tax bracket and expects to stay there in retirement. Vespasian likes his company, believes its prospects are good, and wants to retain the shares he owns. At the same time, he wants to minimize any taxation issues for his heirs after he dies. Vespasian has 1,000 shares of company stock in his plan with a cost basis of $10 per share. The stock's market value at Vespasian's retirement is $50 per share. He expects those shares to increase in value at a rate of 9% per year. He is considering a transfer of these shares to either an IRA or a non-IRA account.
If Vespasian puts the shares in his IRA, he has no immediate tax impact to worry about. But he could still sell the stock immediately, withdraw the $50,000 in sales proceeds from his IRA, and pay federal income taxes of $14,000, thus netting a total of $36,000. (Note: He could also get the same result by using the fourth option. Any subsequent gains at the time of a future sale would then be eligible for capital gains treatment.)
Most likely, though, Vespasian will let the shares sit in his IRA. At a 9% expected growth rate, his shares would be worth $76,931 in five years. If he cashed in those shares at that time or if he died, then he or his heirs (ignoring the spouse's ability to take over his IRA) would face a federal income tax bill of $21,541. That means he or his heirs would net $55,390 after paying the federal income tax due on the sale.
For comparison, if Vespasian takes the shares today, he would pay $2,800 in ordinary federal income taxes on his $10,000 cost basis. He could then immediately sell those shares for $50,000 and pay long-term capital gains taxes of $8,000 to net $39,200 (after we also consider his original tax bill). That's some $3,200 more than the IRA would produce following the same procedure. But, again, it's more likely Vespasian would wait before cashing in those shares. In five years, the shares would sell for $76,931 just as they would in the IRA. His gain, though, would be taxed at a capital gains rate of 20%, which means his tax bill would be $13,386, and he would net $60,745 after we also deducted the original tax bill he paid on those shares at retirement.
If we consider the lost "opportunity cost" as 9% on that original tax payment of $2,800, then we should deduct another $1,508 in foregone earnings on that $2,800 as well. That would make Vespasian's actual net $59,237, a sum that's still $3,847 greater than that produced by the IRA option. And if Vespasian died five years from now, prior to selling those shares? His heirs would take the stock with a basis equal to its market value at the time of Vespasian's death less the unrealized appreciation in the shares when Vespasian received them ($40,000). Their basis would be $36,931 ($76,931 less $40,000).
If they sold everything immediately, they would owe Uncle Sammy a long-term capital gains tax on the unrealized appreciation of $40,000, for a maximum long-term capital gains tax of $8,000. They would owe nothing on the gain from the date of Vespasian's retirement to the date of his death. Vespasian's heirs would thus net $68,931, some $13,500 more than they would have if the shares were in Vespasian's IRA. If they continue to hold those shares, all gains above their basis will be taxed at long-term capital gains rates in the year of sale regardless of how long they hold them.
In Vespasian's case, taking the stock and paying federal income taxes on the cost basis seems the Foolish way to go. By doing so he lessens the potential tax burden for both himself and his heirs. Faced with a similar distribution choice at retirement, that approach may be appropriate for you, too. You'll have to run the numbers to be sure, but at least you're aware of the option.
OK, now you have a general idea of how to take retirement plan and stock distributions. What's next? Getting the Loot to an IRA, that's what.